The market appears to misunderstand the Fed’s reaction function and is pricing a path of policy that is not consistent with a return to 2% inflation. Inflation moderates through demand destruction when households can no longer afford the price increases. But the sources of household purchasing power – credit, wages, and wealth – all appear to easily support elevated inflation. These metrics may not indicate that a 9% inflation rate is sustainable, but they are much too high for a 2% target inflation rate. The market’s eagerness to price in a dovish Fed pivot early next year is worsening the situation by effectively easing financial conditions before inflation has even peaked. This post reviews the strength of household purchasing power along the three sources and suggests a dovish Fed pivot is far away.
Bank lending remains robust with loan growth accelerating to historically high rates despite recent rate hikes. This suggests rising borrowing costs are not deterring borrowers, possibly because their inflation expectations are more influenced by recent inflation prints. Loan growth can potentially continue, as households have strong borrowing capacities given their historically high net worth and rising wages. Note that it is also possible that structural changes in the banking system post-GFC have made higher rates pro-cyclical in credit creation, as rate hikes widen interest margins and encourage lending. The ongoing surge in bank lending is particularly noteworthy because banks create money out of thin air when they make loans. This new money moves through the economy and is part of what makes continually rising prices possible.
Wage growth has been very strong and is likely to remain so amidst an apparent shortage of labor across a wide range of industries. The 5% overall wage growth rate is historically high and appears to be accelerating. Lower income workers, who tend to consume a higher share of their income, are receiving the highest increases. All major labor market indicators suggest continued labor strength, from multi-decade low unemployment rates to a record 2 job postings per unemployed worker. The labor shortage may in part be due to a shrinking work force, in which case the shortage would be structural and less sensitive to higher rates. This suggests an even more restrictive policy would be required to moderate wage increases.
Household net worth rose to a record $150t earlier in the year largely from asset inflation and is still notably above pre-pandemic levels after recent declines. Even the price of Bitcoin is twice its pre-pandemic levels (Dogecoin’s price is 30x higher). On the liability side, many households improved their net worth by refinancing their debt and locking in historically low interest rates. The Fed’s tightening stance has reduced asset prices, but the market is undoing the declines by pricing in a dovish Fed pivot and rekindling risk sentiment. A stubbornly high level of household wealth would make higher inflation affordable and a return to 2% inflation rate less likely.
It’s Not Enough
The market’s implied path of policy appears to misunderstand the Fed’s priorities. Over the past few weeks the market has more aggressively priced in rate cuts in early 2023 following a string of weak economic data. The Fed’s current priority is inflation, and then full employment. This means declining economic activity is a desired outcome of monetary policy and not a reason for a dovish pivot. Nominal spending fueled by wages, wealth, and credit continues to grow at an exceptional rate, suggesting that monetary policy may still be too accommodative. The market’s move to price in rate cuts is effectively easing financial conditions when the effects of tightening are just materializing. The Fed will have to strongly push against market pricing to retighten monetary policy.